The importance of credit scores and how they work
Posted September 15, 2016
If you don’t know a lot (or even anything) about credit scores, you’re not alone. About half of consumers surveyed by Experian, a credit reporting agency, recently said they were “only somewhat knowledgeable” about credit scores.
But it's a topic that people should be more educated about, experts say, since lenders, landlords and even some retailers use the information to determine if they want to do business with you.
“Credit scores play a role in almost any financial transaction you might engage in,” said Rod Griffin, director of public education at Experian, even for something like purchasing the newest iPhone. “I don’t think people realize that … and so they may not get the latest phone, because their credit scores don’t qualify.”
Need for credit
While consumers soon realize credit scores come into play when applying for a loan, a credit history can also become a factor in renting an apartment, signing up for utilities or buying insurance, cellphones or other big-ticket purchases, Griffin said. And if one's history of borrowing and paying back checks out, consumers remain unaware.
“Everyone needs to know about credit reporting and scoring because it’s such an important part of financial life, and their life in general,” Griffin said. “And it shouldn’t seem like a mystery.”
Brittani Bushman, a financial counselor at nonprofit AAA Fair Credit Foundation in Salt Lake City, concurred that it’s “unrealistic” to think that you can forge a life without good credit.
“With society nowadays, credit and credit scores are becoming even more crucial,” she said. “It doesn’t necessarily just impact loans and credit cards anymore.”
Salt Lake City resident Eric Watkins, a synthetic oil dealer, learned about credit quickly after a divorce eight years ago. He found that a 10-year period of credit inactivity was a red flag that would prevent him from doing business across the country.
“I thought that having nothing on your credit card would show that you’re a great person,” he said. “It isn’t.”
With all that credit impacts, it’s vital to have a track record of borrowing and paying back, Bushman said. No history or a bad credit history could mean higher interest rates on loans, if not outright denial.
For those who have no credit history, Bushman recommended they start building it. While she doesn't recommend taking out a student loan unless absolutely necessary, she said paying off a student loan is one way to build up credit, even when it's not in repayment status.
A secured credit card is another way to build credit — it’s a type of card designed to help people build up credit and is available at any bank or credit union. You put money down as collateral, typically at least $200 or $250, and what you put down becomes your credit limit that you can use and pay off, she said.
Once credit is established, your credit card utilization should be around 25 to 30 percent of your card’s credit limit, Bushman said. Keeping it below 30 percent of your credit limit will have an significant impact on your score, she said.
To re-establish his credit, Watkins said he took out one credit card. Then he watched his utilization rate and built up his credit, until banks were automatically increasing his card's credit limit and he was getting better credit offers.
Credit reports and scores
A credit report is a compilation of your credit history that shows how you’ve managed your debt, while a credit score assesses your record with a number.
Griffin said to think of a credit report as a paper you’ve written for school and a credit score is the grade you receive on it.
The three major credit-reporting companies — Experian, Equifax and TransUnion — compile credit reports, and credit scores are handled by other agencies such as FICO. The setup can lead to the misconception that a person has three credit scores, when it's actually three credit reports and multiple scores, Griffin said.
“We don’t decide whether you’re approved or declined, we don’t make recommendations in any way,” Griffin said of Experian. “We just compile that information.”
The scores that appear on reports from the three major reporting firms are usually within a few points of each other, and the middle score is often used as the deciding score. If there is a wide variance between scores, that tells the lender something’s up that needs to be looked into, he said.
There are varying scores for various kinds of loans, with a mortgage lender’s score differing from what an auto lender’s would be, Griffin said. FICO and its scoring system is the most well known, but there are other scoring systems, Griffin noted.
“You hear people talk about THE score, and there’s no such thing,” Griffin said.
For the FICO scoring system, anything below a 579 is considered "Poor," and anything above a 670 is considered "good" or better, Griffin said.
But every scoring agency uses the same information from your credit report in their calculations, it’s just how the information is weighed that differs, Griffin said. The different kinds of lenders calculate scores to predict the odds that their particular type of customer will repay them, Griffin said.
Bushman said that there are five main factors that go into determining a credit score:
- Your payment history (makes up 35 percent of your score)
- The amount you owe (30 percent)
- The average length of your history (15 percent)
- New credit or new inquiries (10 percent)
- The different types of credit accounts you have (10 percent)
Knowing the factors that go into determining a credit score, along with the need to keep credit utilization low, was what was most helpful in re-establishing his credit, Watkins noted.
Income is not part of a credit report or credit score calculation, Griffin noted. The reality is that income isn’t helpful in predicting if a person will pay their debts.
“Having income doesn’t mean you’ll use that income to pay your bills,” Griffin said. “You could have millions of dollars in the bank and not use it to pay your existing debts.”
Similarly, there’s nothing in a credit report about bank accounts such as checking or savings, Griffin said. What the report does is reflect your debt and credit relationships and predict your likelihood to repay the debts you have.
A few more myths on credit scores that Griffin cleared up:
- Most employers can't get credit scores in the limited reports they can access so they can't use the information in hiring someone.
- Requesting your credit report won’t impact your credit score. You can look at it “as often as you like.”
- Inquiries, defined by FICO's website as when lenders ask for a copy of your credit report after you've applied for new credit, impact your score minimally and for the short term. “People worry too much about inquiries,” Griffin said.
- Shopping for the best rates on a home loan or an auto loan will at most count as one inquiry, and depending on the scoring system may not count at all.
“If you take care of your credit report, all of your credit scores will take care of themselves,” Griffin said. “If you manage your credit report well, you will have good credit scores.”
Two things that will ensure good credit: 1) pay your bills on time, and 2) keep credit card balances low, ideally paying it off each month. Everything else builds on that, he said.
It’s also a good idea to view your credit report at least once a year, he said. And watch for any risk factors.
Every time a credit score is calculated, so are risk factors, and these are “probably more important than the number itself,” when it comes to knowing what to do to get a better score, Griffin said. Risk factors can include late payments or bankruptcy, and there could be as many 300 risk factors in a credit score, he said.
“The numbers from different scoring systems can be very different,” Griffin said, “but the risk factors tend to be very consistent. So if you work on the risk factors from one score, then all of your scores will get better.”
Bushman agreed that a credit report is something to be tracked, as she said 80 percent of credit reports contain some kind of error. That error could be anything from a falsely reported late payment to the wrong address listed to being mistakenly reported dead.
A free credit report, provided under federal law, can be found at www.annualcreditreport.com, Griffin said.
Watkins recommended staying on top of credit and know what it can do for you. The world he grew up in before the internet was different, without today’s instant access to scores.
“Because you have all of this knowledge and power at your fingertips, then you could be the controller of your destiny, your business, or your credit,” Watkins said. “Don’t wait, utilize it.”
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